Even though Merkley-Levin didn't make it into the Senate bill, there's still a chance that the Merkley-Levin language will make it into the conference report, so I want to respond to the defenses of the amendment that were offered. (My original post is here.) Mike Konczal wrote a post defending Merkley-Levin that was badly confused, on several levels.

First, Konczal writes:

I think Merkley-Levin is way ahead of this critique, and what EoC doesn’t mention is that the bill provides for this. In case they excluded too much from permitted activities at the statutory level, regulators can add some provided it meets a certain threshold (p. 10):

‘‘(d) PERMITTED ACTIVITIES…(I) Such other activity as the appropriate Federal banking agencies, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, jointly determine through regulation, as provided for in subsection (c), would promote and protect the safety and soundness of the banking entity or nonbank financial company and the financial stability of the United States.

If there are activities that could be justified in promoting safety and soundness, regulators can include them into the bucket of permitted activities. Note that this is a fairly high bar to hurdle, so regulators have to make a fairly good excuse to go for it.

This is not a point in Merkley-Levin's favor, and I have no idea why Konczal thinks it is. The point I made was that the 9 categories of "permitted activities," which function like exceptions to a ban on proprietary trading, were way, way too broad, and would effectively swallow the prop trading ban. The provision Konczal cited is one of the 9 categories of permitted activities. It's what's known as a "catch-all" exception. Essentially, this says that in the unlikely event that a trade can't be justified under one of the 8 other ridiculously broad exceptions, there's yet another catch-all exception the trade could potentially fall under. This does not help Konczal's argument.

Next, he cites section (d)(3) of Merkley-Levin, which provides:

(3) CAPITAL AND QUANTITATIVE LIMITATIONS.—The Board, in consultation with the Securities and Exchange Commission and the Commodity Futures Trading Commission, shall adopt rules imposing additional capital requirements and quanitative limitations regarding the activities permitted under this section if the Board determines that additional capital and quantitative limitations are appropriate to protect the safety and soundness of the banking entities and nonbank financial companies engaged in such activities.

This provision is completely irrelevant. It essentially just says that regulators can raise capital requirements of impose quantitative limitations in order to protect the "safety and soundness" of the BHC. Uh, great, but prudential regulators already have that authority. (In fact, for technical reasons, this provision of Merkley-Levin would almost certainly have to be stripped out, because it would directly conflict with several other provisions of existing law. Like I said, very poor drafting.)

Finally, Konczal makes the "it's a floor, not a ceiling" argument. He notes that Merkley-Levin gives regulators the authority to force BHCs to terminate activities that the regulator determines are "intended to evade the requirements of this section (including through an abuse of any permitted activity)." This misses the entire point, which is that prop trades wouldn't need to evade the requirements of Merkley-Levin — they would be fully compliant with the requirements of Merkley-Levin. Virtually all prop trades would fit legitimately under one of the categories of "permitted activities." It would not be "an abuse of [a] permitted activity" — it would be exactly what Merkley-Levin contemplates, and in fact codifies. And that's precisely the problem.

So yes, Merkley-Levin is still a joke. I have quite a bit of experience in this area, and I guarantee that if the Merkley-Levin language makes it into the conference report, Wall Street will shred it, and continue prop trading just as before. Fighting for the Merkley-Levin language does not make you "tough on Wall Street." It makes you naïve.

An anticlimactic ending in the Senate tonight. Neither of the big post-cloture amendments — Brownback's auto-dealer CFPA exemption and the Merkley-Levin amendment— ended up getting votes. Brownback will get a vote on a motion to instruct the Senate's conferees on Monday. Instructions to conferees are non-binding, but winning on a motion to instruct would give Brownback substantial leverage in conference, since the House bill contains an auto-dealer exemption already. So don't write Monday's vote off as unimportant just because it's non-binding; the Senate takes these things seriously, and it could very well determine whether there's an auto-dealer exemption in the final conference report. (And for the record, I think exempting auto dealers from the CFPA is an awful idea.)

I don't know exactly how it went down, but Merkley and Levin caved as well. I suspect that Reid and Dodd promised to designate Merkley and Levin as conferees with the authority to negotiate the Volcker language only. Either that, or Reid and Dodd adequately assured them that they'll "do everything they can" to protect the Volcker Rule in conference. Frankly, I hope it was the latter, since as I wrote earlier, the Merkley-Levin language was terrible. Better to get someone who actually understands the language of U.S. banking law negotiating the Volcker Rule in conference.

I know the banking industry is going to freak out about the fact that Blanche Lincoln's disastrous Sec. 716 is still in the bill, but they shouldn't sweat it. It will get stripped out in conference — everyone (save for Blanche Lincoln) recognizes that Sec. 716 simply cannot become law. Dodd knows what he's doing.

The next thing to watch is who gets appointed as conferees. In the Senate, Dodd and Shelby will obviously be conferees. Lincoln and Saxby Chambliss, as chair and ranking member of the Ag Committee, will also be conferees, although I wouldn't be surprised if they're only given authority to negotiate on the derivatives title (Lincoln's Sec. 716 stunt didn't go over well in her own caucus). Jack Reed and Bob Corker are also two likely conferees, given their superior command of the nuts-and-bolts of financial regulation.

Personally, I'm just glad we have a financial reform bill going to a conference committee that doesn't include Phil Gramm. I blame him personally for the incredibly convoluted state of the CEA (the derivatives law).

Cloture vote at 2 p.m. today, which would start the 30-hour clock, and put the final vote on financial reform at 8 p.m. tomorrow. Yes, I think Reid has the votes on cloture. I know Dorgan, Levin, and Cantwell have suggested that they won’t vote for cloture unless they get a vote on their respective amendments, but when it comes down to it, I don’t think they’ll have the stomach to vote against cloture on Wall Street reform. (Or, more accurately, I don’t think they’ll have the stomach to be the deciding vote against cloture on Wall Street reform.) I think Reid is calling their bluff. We’ll know at 2 p.m. today though.

Dodd offered a compromise at the last minute on Blanche Lincoln’s disastrous Sec. 716, which would require regulators to study whether banks should be forced to spin-off their swaps desks, and then essentially make a recommendation to the Treasury Secretary. The banks are not at all happy with Dodd’s compromise though. Personally, I think they’re being ridiculous — this is the legislative equivalent of striking the language entirely.

The Republicans will probably offer a second-order amendment to Dodd’s compromise, which will weaken it even further, and that will probably be enough to get some Republicans on board. I know some so-called “reformers” will probably portray this as a huge loss for progressives. It’s really not. It doesn’t make the bill “less progressive,” it makes the bill “less ridiculous.”

As to all the Merkley-Levin nonsense, I’m obviously not upset that it failed. It was a bad amendment, and Wall Street would have eviscerated it without even breaking a sweat. (And memo to Merkey’s office: if you think you were just respecting the principle of “international comity,” then you got rolled by the banks’ lobbyists. You were not.)

It’ll be interesting to see if Merkley and Levin try to bring up their amendment post-cloture. To do so — that is, to prove the germaneness of their amendment — they would essentially have to admit that there’s already a Volcker Rule in the Dodd bill, which is something they’ve gone to great lengths to obscure to the press.

I'm no longer worried about Blanche Lincoln's Section 716 proposal (i.e., the swaps desk spin-off). One way or another, it will get taken out. I'm satisfied on that front. I'm maintaining my earlierprediction that the Dems will end up stripping Section 716 in a post-cloture amendment. Lincoln's primary — in which she's facing a tough challenge from the left — is on Tuesday, and no one wants to take her legs out from under her at this point. So the best way to handle this is to let Gillibrand file her amendment to strike before Reid files cloture; vote for cloture with Lincoln's Section 716 language still in the bill (giving her the symbolic/media victory); and then after Lincoln's primary, vote on Gillibrand's amendment to strike — which would pass with 70 votes, at least. Everybody wins. The cloture vote is expected to be on Tuesday, which would put the vote on Gillibrand's amendment to strike on Wednesday or Thursday. They could also strip Section 716 in a post-cloture manager's amendment, but I think the Gillibrand amendment is the more likely path.

Fun fact: the Dodd bill requires 28 studies to be completed in the next 2 years. Sixteen of the studies have to be done within the first year after the bill is enacted. The GAO alone has to do 11 new studies. (Have fun!)

I don't think there's any way interchange survives conference. The ICBA, which represents community banks, lobbied heavily against Durbin's interchange amendment. Community banks wield an enormous amount of power in the House (community banks are in everyone's district), so interchange will probably be the first thing the House strips from the bill in conference. I also seriously doubt that Franken's rating agency amendment will survive conference. I haven't really decided how I feel about Franken's rating agency reform yet; I honestly just haven't thought about it enough.

I'm not entirely sure what's going to happen with the provision imposing a fiduciary duty on dealers when trading with pension funds, endowments, or governmental entities. It's another provision that's just unworkable — among other problems, I'm pretty sure ERISA prohibits pension funds from transacting with fiduciaries (under the "party in interest" prohibition, I believe), so a fiduciary duty requirement would have the effect of barring pension funds from transacting with any dealers. Clearly, supporters of this provision have confused it with the issue of whether broker-dealers should have a fiduciary duty when giving investment advice. If this provision survives the Senate, it'll definitely get taken out in conference; I'm not too worried about that. But I don't know if it'll get stripped out in the Senate. I suspect it won't at this point.

The Merkley-Levin Amendment (SA 3931) is a version of the Volcker Rule. The Volcker Rule, if you'll recall, is a ban on proprietary trading at banks and bank holding companies (BHCs). If you ask Merkley and Levin's offices, they'd no doubt tell you that their amendment significantly strengthens the existing Volcker Rule language in the Dodd bill (Section 619 of S.3712). Don't be fooled — it does nothing of the sort. I spent the majority of my career as a lawyer for one of the big investment banks, and my first thought after reading Merkley-Levin was: "Wow, this would be cake to get around." Wall Street is scared of the Volcker Rule, but believe me, they're not scared of Merkley-Levin.

This requires a bit of explanation. To ban prop trading at BHCs, the law must distinguish between market-making trades and propietary trades. Market-makers stand ready and willing to buy or sell securities for their own account, at firm bid and offer prices. If an investor is looking to sell a security, the market-maker will buy the security using its own capital, and hold it in inventory until an investor who's looking to buy the security surfaces. Holding many inventories of securities (i.e., bonds, stocks, derivatives) exposes market-makers to all manner of short-term market risk, interest rate risk, foreign exchange risk, etc. This requires market-makers to do quite a bit of hedging in order to safely carry these inventories. We don't want to prevent banks from hedging the inventories they hold as market-makers, but we dowant to prevent banks from entering into trades that aren't intended to hedge a risk associated with its market-making activities — that is, purely speculative prop trades. This is a difficult and complicated task, but it can be done (I've seen it done from the inside).

Ideally, what the financial reform bill would do is just say, "Proprietary trades are banned; market-making trades are allowed," and then let the regulators work out how to define "market-making trades" and "proprietary trades." This is something that simply can't be done at the statutory level; it has to be done at the regulatory level. Unfortunately, these days it's fashionable for people to bash any sort of regulatory discretion as tantamount to letting Wall Street win. This is where Merkley-Levin comes in, because it's clearly a response to this "anti-regulatory discretion" meme.

The biggest problem with Merkley-Levin is that its authors appear to confuse "definitions with more words" with "more specificdefinitions" (and thus less of that evil regulatory discretion). Merkley-Levin prohibits "proprietary trading," which it defines very broadly, and then creates 9 categories of "permitted activities" (listed in section (d)(1) of the amendment). The categories of "permitted activities," which function like exceptions to the definition of "proprietary trading," are so ridiculously broad that they completely swallow the amendment's prop trading ban. The most important exceptions are sections (d)(1)(B), (C), and (G).

First, let's take section (d)(1)(B), which explicitly permits:

(B) The purchase, sale, acquisition, or disposition of securities and other instruments described in subsection (i)(4) in connection with underwriting, market-making, or in facilitation of customer relationships, to the extent that any such activities permitted by this subparagraph are designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties.

Section (B) was obviously supposed to be the generic market-making exception — but notice, crucially, that the term "market-making" is still undefined. Instead of offering a more specific or more narrow definition of "market-making," Merkley-Levin actually weakens the Volcker Rule by creating a whole bunch of new categories of exceptions to the prop trading ban. Essentially, section (B) consists of three separate categories of permitted trades: (1) trades "in connection with underwriting"; (2) market-making trades; and (3) trades "in facilitation of customer relationships." Regulators still have to use the rulemaking process to define "market-making," which will no doubt encompass any trade which can be justified as a hedge against any risk the bank faces in its trading book.

But even if a trade can't be justified as part of the bank's market-making activities, there's literally no trade that can't be justified as "in facilitation of customer relationships." As long as the counterparty on the trade has some sort of trading relationship with the bank (e.g., the counterparty is a prime brokerage customer, or has an ISDA Master Agreement with the bank), then it's very difficult to see how the trade wouldn't come under the definition of a trade done "in facilitation of customer relationships." All counterparties are "customers" of the bank on some level, and because every trade has to have a counterparty, literally every trade could be justified as "in facilitation of customer relationships." And remember, the exception for trades "in facilitation of customer relationships" is in addition to the exception for "market-making" trades.

The limitation that any trades allowed under section (B) have to be "designed to not exceed the reasonably expected near term demands of clients, customers, or counterparties" isn't a serious limitation. At most, it would just require a trader to come up with a plausible explanation for why he decided to take on a certain position — which could be satisfied by a story about what the trader thought other market participants were going to do at the time.

Next, we have section (C), which permits:

(C) Risk-mitigating hedging activities designed to reduce risks to the banking entity or nonbank financial company.

Whereas the exception for market-making in section (B) will no doubt include trades which hedge risks in the bank's trading book, section (C) goes one step further, permitting trades which can be justified as hedging any risk in the entire BHC, not just risks in the trading book. Also, I'd expect the banks to argue that "diversification" reduces risks to the banking entity as a whole, and thus that trades which have the effect of diversifying the bank's portfolio are permitted under section (C).

Finally, we have section (G), which permits:

(G) Proprietary trading conducted by a company pursuant to paragraph (9) or (13) of section 4(c), provided that the trading occurs solely outside of the United States and that the company is not directly or indirectly controlled by a United States person.

Section 4(c)(13) of the Bank Holding Company Act is an exemption which permits certain BHCs to own foreign bank subsidiaries (and certain foreign companies). Goldman, Morgan Stanley, JPMorgan, even CIT Group — they all own foreign bank subsidiaries under section 4(c)(13). To my knowledge, all the major BHCs own foreign bank subsidiaries under section 4(c)(13).

So essentially, section (G) allows BHCs to continue their prop trading through their London offices, provided they find non-US counterparties (shouldn't be too difficult), and the trading isn't being controlled by someone in New York (fine, just send all your prop traders to London). And this is in addition to all the prop trading the banks could do out of their New York offices under the ridiculously broad "permitted activities" in sections (d)(1)(B) and (C). Seriously, this would be like taking candy from a baby for the dealer banks.

Now, I should tell you that I'm assuming that section (d)(2)(A)(i) of the Merkley-Levin Amendment will either be removed, or defined away by regulators. It's basically incompatible with the clear intent of the amendment, so I'm pretty confident that it'll be taken out (if not in the Senate, then in conference). Section (d)(2)(A)(i) prohibits even permitted activities if they:

(i) would involve or result in a material conflict of interest (as such term shall be defined jointly by rule) between the banking entity or the nonbank financial company and its clients, customers, or counterparties.

This is simply incompatible with market-making, which involves taking the opposite side of clients' trades, and it's the clear intent of Merkley-Levin to allow market-making. If for some bizarre reason this section doesn't get removed, regulators would have to consider the clear intent of the amendment to allow market-making in defining "material conflict of interest," and would effectively be forced to define "material conflict of interest" so narrowly that it might as well not exist as a limitation. The fact that this section is even in the amendment I think is indicative of how poorly it was drafted.

People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.

The idea arose from a mix of policy debate, campaign politics and personal relationships -- and little consideration of the business or economic implications, according to interviews with Senate aides, administration officials and industry lobbyists.

Read the whole article. Oh by the way, Paul Volcker has now also come out against Section 106. Sheila Bair penned a letter to Lincoln sharply criticizing Section 106 last week, and the Fed circulated a memo on the Hill a couple weeks ago arguing that Section 106 should be deleted.

Of course, it looks like the usual suspects on the left will still loudly support it, because right now, pretending to fight Very Important battles with Wall Street on financial reform is really all they care about. Unfortunately, "experts" like Michael Greenberger and Robert Reich have already come up with absurd/dishonest arguments for why this is actually "real reform" that the left should fight for, and why anything less would be a give-away to Wall Street. They should be embarrassed.

Greenberger, for instance, is apparently willing to claim, with a straight face, that major nonbank swap dealers "would not [be] shadow banks." I kid you not. That's how far defenders of Section 106 have to twist their logic. And Reich arguably one-upped Greenberg yesterday with this doozy:

Senator Blanche Lincoln, Democrat of Arkansas, has pushed an amendment that would force big banks to spin off most of their derivative businesses — bringing derivatives into the open and insulating them from the kind of proprietary trading that can cause so much havoc. But the Administration thinks Lincoln is going too far and has instructed its allies in the Senate not to go along. Lincoln should stick to her guns.

Wow. That's just incoherent. Reich apparently thinks that pushing the vast majority of swaps away from banking regulators would be "bringing derivatives into the open." That claim literally makes no sense. Also, it's 100% untrue that Section 106 would "insulate" banks from proprietary trading. The whole point is that Section 106 doesn't distinguish between prop trading and market-making. It bans banks from doing both. Reich clearly has no clue what Lincoln's Section 106 proposal is even about — and yet he's already declared that failing to support it would be "pandering to Wall Street."

Look, this isn't difficult. Swaps are a critical part of modern banking. Just like normal commercial lending requires banks to serve as intermediaries between savers and borrowers, the swaps market also requires intermediaries (known as dealers, or market-makers). These intermediaries borrow short and lend (through swaps) long; they are susceptible to runs; and their disorderly failure can cause severe collateral damage to the real economy. Pretending that swap dealers aren't engaged in an important banking function by refusing to call them "banks" is not just delusional, it's also dangerous. And yet this is what Blanche Lincoln's Section 106 proposal aims to do.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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